As emerging markets wrestle with trade-related woes and the dollar, is the pain over?

Emerging-market equities, one of the top-performing segments of the global economy in 2017, have undergone a dramatic reversal thus far this year, tumbling amid the twin headwinds of a stronger U.S. dollar and ongoing trade uncertainty between the U.S. and China.

The region has been among the hardest hit by trade headwinds, particularly this week, after President Donald Trump threatened tariffs on some $450 billion more in Chinese products. The Trump administration dialed up the rhetoric late Tuesday, accusing China of waging a systematic campaign of “economic aggression” in a report released Tuesday.

The group has also been pressured by a rise in the U.S. dollar
DXY, +0.38%
one measure of which is up 5.4% since the start of April. Emerging-market stocks often have an inverse correlation with the U.S. dollar because many borrow in the greenback, and then have higher costs of paying that back as it strengthens.

“Not only are emerging markets are facing the brunt of the trade discussions, but the bigger impact on them is the dollar. These stocks might be able to absorb a 5% or 10% rise, but if there’s something bigger, the negative impact could be much stronger, and it could prompt us to reassess our position on the category,” said Lance Humphrey, executive director of global multi-assets at USAA.

Humphrey’s firm has an “overweight” rating on emerging-market stocks, and he said the recent declines represented a good buying opportunity. The trade and dollar issue, he added, “don’t represent a fundamental deterioration in the region’s economies, though we are watching they closely.”

While China and India are the emerging-market economies that tend to get the most attention, other specific regions have also seen volatile activity of late. Argentina’s central bank recently raised its policy interest three times in just eight days; it also sought financial support from the International Monetary Policy. Turkey’s central bank has also been hiking rates in response to a tumbling currency.

The Vanguard FTSE Emerging-Markets ETF
VWO, +0.60%
one of the largest EM-focused funds and the most popular ways for investors to get exposure to the category, has lost 9.7% over the past three months, a decline that has been enough to push it into negative territory for the year. It is now down 5.9% for 2018.

Similar weakness has been seen in two other widely used exchange-traded funds. The iShares MSCI Emerging Markets ETF
EEM, +0.61%
is down 6.8% in 2018, and it has shed nearly 11% over the past three months. The iShares Core MSCI Emerging Markets ETF
IEMG, +0.64%
has had almost identical declines.

Jonathan Garner, the chief Asia emerging-market equity strategist for Morgan Stanley, on Wednesday cut his targets for the regions “as macro pressure points build materially.” According to the investment bank, Garner “sees downside from here for all his coverage markets near term,” and speculates that EM overall “should” enter a bear market, defined as a 20% drop from a peak. Currently, all three EM ETFs are down about 15% from their 52-week peaks.

Analysts at JPMorgan also forecast additional downside ahead in the group, saying it was too soon to add to positions.

“Now that EM equities have been stalling for a while, delivering a negative total return of 520 basis points versus [developed markets]year-to-date, the question is, should one add risk to the group? We still think that this would be premature and stay out of EM equities for now,” wrote Mislav Matejka, the firm’s chief European equity strategist. “For EM to rally, we believe we need to see EM [currencies] bouncing and the U.S. dollar resuming its downtrend, but the interest rate differential still appears strongly U.S. dollar positive.”

Matejka said “there will be a better entry point” and that “the time to buy is approaching.”

According to FactSet, the category of emerging-market equity ETFs have seen outflows of $5.39 billion over the past month, the most of any type of fund category. Much of that has come over the past week, a period over which $4.1 billion has been pulled from the group, an amount that also represents the steepest outflows of any fund type. However, year-to-date flows remain positive, with more than $7 billion entering the space, which has nearly $167 billion in total assets.

These losses have come at a time when emerging-market economies and stocks have otherwise been growing. Based on the holdings of the Vanguard ETF, emerging-market stocks have average annual sales growth of 9.94%, a price-to-earnings ratio of 21.34, and a dividend yield of 2.38%. To compare, the components of the S&P 500
SPX, +0.64%
offer a lower yield of 1.9% and a higher P/E, of 33.53. However, U.S. stocks also have higher revenue growth, at 10.86%.

On the other hand, the dollar’s gains and the headwind of trade issues have been eroding profit expectations for the region. According to FactSet, analysts expect earnings growth of 10.9% for EM stocks. That is down significantly from the 19.3% growth rate that was expected in early March. On a per-share basis, the expectations have gone from $3.61 to $3.37.

The Wells Fargo Investment Institute has a near-term neutral view on emerging-market stocks.

“Improvements in global economic growth, and a rise in domestic consumption and investment in EMs, have supported EM corporate balance sheets. Looking forward, we expect positive EM economic growth this year to underpin the positive earnings environment,” wrote Bobby Zheng, an investment strategy analyst at the firm. “Systemic risk ‘contagion’ in these markets today is still possible. Yet, it seems less likely than it did in the past, when EMs had very substantial dependence on the U.S. and other developed economies.”

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